Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Why does SEC think that 333,251 minus 5 times 66,421 is not 1,146?

The CME futures contracts on the S&P 500 index comes in two flavours – the big or full-size (SP) contract is five times the E-Mini (ES) contract. For clearing purposes, SP and ES contracts are fungible with a five to one ratio. The daily settlement price of both contracts is obtained by taking a volume weighted average price of both contracts taken together weighted in the same ratio.

Yet, according to a recent SEC order against Latour Trading LLC and Nicolas Niquet, a broker-dealer is required to maintain a net-capital on the two contracts separately. In Para 28 of its order, the SEC says that in February 2010, Latour held 333,251 long ES contracts and 66,421 short SP contracts, and it netted these out to a long position of 1,146 ES contracts requiring a net capital of $14,325. According to the SEC, these should not have been netted out and Latour should have held a net capital of $8.32 million ($4.17 million for the ES and $4.15 million for the SP). This is surely absurd.

It is not as if the SEC does not allow netting anywhere. It allows index products to be offset by qualified stock baskets (para 10). In other words, an approximate hedge (index versus an approximate basket) can be netted but an exact hedge (ES versus SP) cannot be netted.

PS: I am not defending Latour at all. The rest of the order makes clear that there was a great deal of incompetence and deliberate under-estimation of net capital going on. It is only on the ES/SP netting claim that I think the SEC regulations are unreasonable.


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